Financing Options for PRC Water Projects

Email this article to a friend

Mitchell A. Silk & Simon Black

July - August 2000
Issue:

Cover by Benjamin A. Hurd

China is focusing on building water-treatment plants nationwide, and is allowing foreign investment to take some innovative forms

Mitchell A. Silk is a partner with the Allen & Overy Asia project group, Hong Kong.

Simon Black is a consultant with the Allen & Overy Asia project group, Hong Kong.

Both acted as counsel to the lenders in the Chengdu project financing.

Major foreign water companies such as Suez Lyonnais des Eaux, Thames Water, and Vivendi have already invested in the sector via technology transfer, training and technical assistance, water and wastewater treatment management, and wholesale ownership of treatment facilities. However, the scale of foreign participation has barely scratched the surface of the potential demand.

The Beijing No. 10 Tendering Office is rumored to be surprised (and no doubt delighted) at the tariffs bid by some foreign firms.

Water treatment has climbed considerably on China's list of infrastructure priorities over the past two years. Water projects are relatively less capital intensive and low tech than projects in other infrastructure sectors. However, developing the sector has posed considerable challenges to China's policymakers and regulators, and, in turn, to foreign participants. A look at some of these challenges, particularly the legal and regulatory issues most relevant to foreign companies, suggests possible routes that the private sector can take to help the country achieve its goal of providing efficient and reasonably priced water services.

One option for foreign participants, which has received much attention over the years in the power sector in particular, is the build-operate-transfer (BOT) model, in which a project company undertakes the construction, operation, and financing of a facility during a limited concession period. Another option for foreign investors is investment through the traditional PRC joint-venture (JV) structure, with the Chinese partner role filled by a municipal water utility that plays numerous, and sometimes conflicting, roles in the project.

The scale of the challenge: water shortages, structural impediments

Inadequate resources, insufficient supply infrastructure, contaminated raw (untreated) water sources, and a natural resource imbalance in China's water sector all contribute to an acute water shortage in China's cities. The central government has classified 300 cities as short of water, 108 as having serious water problems and 60 as being critically short of water. The country also suffers from low per capita water resources in terms of rainwater and groundwater reserves, water reserves per hectare, and water reserves per capita. A geographic imbalance further exacerbates this lack of resources. Northern China holds only one-fifth of the per capita resources of southern China, though both have roughly equal water needs.

Ineffective management of resources contributes to shortages as well. Ditch irrigation systems waste 60 percent of the water used in the agricultural industry and also contributes to pollution through pesticide run-offs. In the industrial sector, enterprises tend not to recycle water and in all sectors, outdated production technology creates further excessive wastage. The result is that China may need to increase its water supply capacity 25 percent by 2010. This equates to building roughly 600-800 new water-treatment plants similar to the recently completed Chengdu No. 6 plant, which has a capacity of 400,000 cubic meters per day (cmpd), although updating current technology, improving wastewater treatment, and institutional reform will also help achieve this goal.

Foreign investors can help China meet this challenge by bringing financial capital, new technology, and human expertise to its water-sector investments. Major foreign water companies such as Suez Lyonnais des Eaux, Thames Water, and Vivendi have already invested in the sector via technology transfer, training and technical assistance, water and wastewater treatment management, and wholesale ownership of treatment facilities. However, the scale of foreign participation has barely scratched the surface of the potential demand. In part, this reflect s exaggerated expectations, the relatively limited number of foreign water companies with ambitions in China (compared with the relatively larger number of foreign firms in the power sector) and the general difficulties associated with foreign investment in China. Following are some issues specific to the water sector:

Coordinating approvals Up to 30 agencies at the central, provincial, and local levels have approval authority in any given water project, in diverse areas such as macroeconomic planning, foreign-investment policy, commercial registration, water-resource regulation, foreign exchange, taxation, land administration, sanitation and environmental protection, customs, and construction. Each regulator may be subject to different and sometimes conflicting policy constraints. Lack of coordination in the approval process has led to delays and high development costs, leading in turn to higher tariffs.

Tariffs Water remains a subsidized resource in China, with consumers generally paying less for drinking water than the real cost of production and distribution. This situation threatens the commercial viability of projects particularly for foreign investors facing commercial objectives and constraints. Tariffs are subject to review and approval, generally at the local level, and tariff approval authorities may be loathe to approve tariffs for foreign-owned plants that are out of line with those applicable to domestic plants. Tariffs that are approved on a commercial basis will require that the marginally higher cost of wholesale treated water from privately invested plants, as opposed to subsidized plants, be borne by a local water utility, its water customers, or the foreign investor.

The best and most responsible way to mitigate these risks is to seek a clear, objective, and financially driven tariff structure that also incorporates proper incentives to lower capital and operating costs. Achieving this fine balance, of course, requires all parties to ensure that the risk and reward profiles of all cost inputs be reasonable and responsible, to ensure that the marginally higher tariff indeed reflects market prices to the consumer and market returns to the investors.

Municipal and local risks The success of a foreign-invested plant will depend greatly on the performance of the local water utility, either as joint-venture partner or as offtaker. (As offtaker, the water utility purchases the water from the plant and on-sells to the enduser.) The lack of financial transparency that pervades many Chinese state-owned enterprises and the subsidized, and sometimes inefficient, business conditions under which they operate make issues of credit and performance acute. This has caused some foreign participants to rely on structures guaranteeing rates of return or government support letters that run against the grain of current policy and, in some cases, of PRC regulation.

Foreign participation in the distribution sector would reduce these risks by ensuring direct access to customers, but Chinese law currently prohibits foreign ownership and management of water distribution. In the absence of deregulation in the distribution sector, some projects have sought to ring-fence revenue--that is, dedicate a portion of the local water company's revenue from water customers solely to pay the foreign company--with all the attendant structural and legal risks (discussed below).

Raw water supply In some areas, China experiences shortages of raw water. Falling water tables and industrial pollution have also combined to reduce the quality of raw water. This highlights the need for, first, additional investment in the treatment of wastewater to reduce pollution, and second, fair and transparent management of raw water resources that will not disadvantage foreign investors in water-treatment plants.

Meeting the challenge: models of foreign participation

Traditional models of foreign investment in the water sector can be broadly categorized as either joint-venture structures, often involving unsolicited negotiations with a local partner; and BOT structures, involving a competitive bid and wholesale foreign ownership and operation.

Foreign investors have often used their existing business relations in China to secure investment opportunities in conjunction with a local partner and generally without a publicly announced competitive bid. The joint-venture structures have generally taken the form of "multi-role" structures or "innovative" structures.

The "multi-role" project traditionally comprises a joint venture between the foreign investor and the local water utility whereby the utility assumes most construction, operation, supply, and offtake res ponsibilities and risks. The project seeks to achieve a minimum return to its investors by a minimum offtake at a tariff that reflects the actual cost of construction, operation and maintenance, taxes and reserves, debt service, and minimum equity return (the so-called "cost-plus" tariff).

Risky and high-cost "innovative" structures take varying forms, including offshore debt funded via the foreign shareholder, pooled equity funds, and all-equity funding through construction. The risky nature of innovative structures is evident in the security and comfort arrangements employed. These are generally defensive in approach and stray from a uniform market standard, through the use of guaranteed shortfall payments, support letters, and stand-alone arrangements to make termination payments backed by insurance arrangements.

The combined effect of the varying forms of innovative structures is to create uncertainty and delays, lengthier project-development periods, higher development and capital costs, and higher infrastructure commodity prices for the consumers.

The BOT structure was designed to contain the above risks. The model involves a foreign consortium bidding for a concession from a provincial or municipal government to build, own, and operate a water project throughout a concession period. The bid documents would include a draft concession agreement, an offtake agreement with the local power or water company, and the related technical specifications and financial information.

BOT offers real benefits in the following ways:

Clear risk allocatio n The BOT structure provides a clearer risk allocation by reducing the concentration of performance and credit risk on the local Chinese party and avoiding the real or perceived conflicts of interest that exist under the multi-role structure. The foreign consortium bidding for the concession tends to bear most of the construction and operation risks, and the Chinese parties will assume most fuel or raw water-supply, offtake demand, political, force majeure, and currency risks.

Competitive bidding and tariffs Competitive bidding has increased transparency, fairness, and efficient allocation of resources and expertise, allowing firms to focus on cost and technical factors rather than time-consuming negotiation and political matters. This has increased certainty in the process and reduced tariffs--the water charges paid by the utility. The tariff structure, by providing only for variations to reflect exchange-rate fluctuations and to compensate the consortium in other limited instances, itself acts as an incentive to build and operate efficiently. The move toward fixed tariffs instead of cost-plus tariffs or guaranteed returns has therefore reduced water tariffs and minimized the tariff approval risk.

Pre-packaging of approvals Pre-packaging of approvals in the tender documents removes some of the approval and pricing uncertainty by providing a clearer regulatory path whi ch, in turn, reduces time delays and development costs. It also reduces ongoing regulatory risks, such as the continuance of approvals, tariff adjustment, and foreign-exchange issues.

The BOT model, in different guises, has spawned three water projects. Both Thames's Da Cheng project in Shanghai and Vivendi's Chengdu No. 6 project have reached financial close (see Figure 1). Bidders on the Beijing No. 10 project currently await the announcement of the winning bid (see Figure 2).

Development of BOT

The Chengdu No. 6 water-treatment project benefited from the direct sponsorship of the central-level State Development and Planning Commission (SDPC) under its pilot BOT scheme and also from the Chengdu Municipal Government's effective "guarantee" of the raw water-supply and the local utility's offtake responsibility. Since Chinese law prohibits a government agency from guaranteeing the performance of another Chinese party without the necessary approval, the parties structured the guarantee as a direct undertaking by the municipal government, as "primary obligor," to perform raw water-supply and offtake obligations. While the parties secured all necessary approvals for the structure, the structure contains obvious contradictions, as it appears inconsistent with Chinese policy goal s of separating the administrative and commercial functions of government and minimizing recourse to the government in private infrastructure projects.

Perhaps for this reason, the legal structure for Beijing No. 10 is radically different. Under the umbrella of specific BOT legislation the Beijing Municipal Government has promulgated, the government will designate different functional authorities to act as concession authority, raw water supplier, offtaker, and payor of termination sums. It remains to be clarified what strict legal recourse the concession company would have toward the municipal government if the functional authorities fail to perform their responsibilities. The concession company established by the winning foreign consortium will perform responsibilities similar to those for Chengdu No. 6, namely construction, operation, maintenance, and financing of the plant. It is therefore worthwhile to assess the future direction of BOT in light of the revised structure, which raises some specific questions in the areas of government responsibility, credit support, and cost.

Defining government responsibility The discussion of the Beijing case highlights two potentially conflicting principles. On the one hand, in an increasingly deregulated economy, Chinese policymakers will seek to minimize recourse to the government in private infrastructure projects. On the other hand, the inabilit y to conduct effective investigation into the financial condition of many local Chinese companies forces foreign parties to focus on the role of the government. To solve this conundrum, the BOT project model must better define the governmental rather than commercial responsibilities and, where appropriate and possible, provide effective credit support for commercial responsibility of the local parties, without recourse to government bodies.

Credit support Credit support for the payment of periodic water charges by the water utility to the concession company can take the form of a dedication of funds received from water customers (particularly larger ones) in special "escrow" accounts or the issuance of letters of credit secured on the utili ty's receivables. Beijing No. 10 itself envisages some form of special account, which the tendering office aims to develop with the winning bidder into a bankable structure.

Greater transparency--lower development costs While the BOT scheme has promoted greater regulatory and contractual clarity, many foreign developers would still argue that the development periods are unacceptably long. Since a foreign developer will, during the bidding process, propose a tariff that is based on the projected development costs during the predicted period to financial close, delays beyond that period will increase development costs--directly reducing its return from the project. The delays may have many causes, but the continuing uncertainty on diverse matters such as gov ernment support, land, insurance, foreign exchange, pricing, and security contributes significantly. Furthermore, the approval process, while more transparent than traditional foreign-investment projects, could be accelerated and streamlined to the benefit of all project stakeholders.

BOT bonanza--for some

Promulgation of a comprehensive BOT law would undoubtedly help clarify these issues. The delay in finalizing the draft BOT law currently under discussion probably reflects the high-level debates taking place over the core issues of macroeconomic development and foreign investment. In the meantime, Beijing No. 10 and other projects will probably develop in an ad hoc way. That development may well create the necessary consensus and clarity even without the release of the BOT law. For example, though the legal structure may be different, the basic contractual terms and risk allocation in Beijing No. 10 closely resemble those in Chengdu No. 6. Furthermore, many investors hope that Beijing No. 10 will itself prove a benchmark (in terms of credit enhancement and government support) for other municipal BOT projects.

Because of the higher costs involved, however, BOT is really only viable for the large-scale and therefore relatively rare projects (above 300,000 cmpd). Being rarer, and subject to intense competition amongst the foreign firms, the BOT projects appear to offer foreign fir ms symbolic "flagships" of investment in China rather than generous profit margins. The Beijing No. 10 Tendering Office is rumored to be surprised (and no doubt delighted) at the tariffs bid by some foreign firms. Some tariffs tendered are said to be below the average currently subsidized water price applying in Beijing (RMB1.4-1.5 [$0.16-0.18] per m3). The rarity of the larger BOT projects and their razor-thin profit margins may push foreign investors to look for more profitable investment opportunities elsewhere.

Further development of the JV model

Whatever the challenges in terms of managing relationships and issues of operational and financial control, the joint-venture approach, essentially by default, will remain the only means of meaningful foreign participation in the future. The following issues are particularly conducive to the JV model:

The "cookie cutter" aspect Joint-venture investments, often without limited-recourse debt finance, are likely to remain the standard for the abundant smaller municipal projects (typically in the range of 100,000 to 200,000 cmpd). In order to achieve economies of scale, foreign developers seek to standardize the smaller projects (for example through financial modeling, contractual risk profiles, credit support, technical due diligence, and documentation) in an effort to reduce development costs and increase returns. A portfolio of smalle r projects with similar structures may also provide opportunities for refinancing by limited-recourse structures, such as bond issues, which lower the developer's cost of capital. The differences in policies and attitudes across municipalities limit successful implementation of this strategy.

Municipal risks and pricing issues The JV model's success is also dependent on the ability of the parties to contain the traditional municipal risks. First and foremost, this requires projects to be economically sound and have real and predictable demand for their products. Furthermore, a combination of even-handed construction terms between the joint venture and its Chinese contractor, allocation of risk of changes in law, and political and natural force majeure risks in line with acceptable norms, along with containment of the payment risk on the offtaker, are also necessary. In this respect, the credit-support structures for the local offtaker discussed in connection with the projects above could equally apply to the joint-venture model. Such factors can, in turn, promote a more reasonable and responsible pricing of water treatment in China. The introduction of competitive pressures and incentives would also help reduce prices. For example, Chinese parties could introduce a competitive element by putting joint-venture opportunities out to a simplified form of competitive tender.

Water distribution As mentioned, Chinese law currently restricts foreign involvement in the water distribution sector. This applies equally to joint ventures and wholly foreign-owned enterprises. However, limited construction, and operational and technological assistance in the water- distribution sector, is not necessarily prohibited. As the natural nexus between the foreign and domestic parties, joint ventures provide a better vehicle than the BOT corporate structures to take advantage of these opportunities.

Renminbi (RMB) finance The importance of local equipment procurement and the payment of tariffs in RMB make RMB financing attractive to Chinese water projects. In the BOT cases, Chengdu No. 6 involved no RMB financing while Beijing No. 10 contemplates a possible 50-50 split in the debt portion (some bidders and advisers believe a 100 percent RMB debt portion would have been the cheapest source of finance). A joint venture could take obvious advantage from the links between the domestic partner and local Chinese banks and the less severe regulatory and policy constraints (when compared with wholly foreign-owned enterprises) to maximize use of RMB finance.

Plumbing the depths

The exciting developments in China's water sector are a reflection of the progress the country has made in both economic and industrial development. Great potential demand remains to be tapped, and foreign investors, acting responsibly, can assist Chinese policymakers and regulators in meeting their goals of securing reasonably priced water resources. In turn, however, Chinese policymakers must make significant strides in achieving greater transparency and certainty within the water sector, particularly with regard to the financial standing of the Chinese counter-parties, the regulatory framework, dispute resolution, and the degree of permitted government legal recourse or other support.